Risk-Based Liquidity

When there is financial failure, it comes as a result of illiquidity. Now, truly, these parties are insolvent, because they took the risk of not being able to pay cash when it was due. Illiquidity and insolvency are really the same thing, though many obfuscate.

If you can’t pay cash, it doesn’t matter what your assets are worth in “normal” times. Banks should have planned in advance to make sure liquidity was always adequate, rather than doing the usual borrow short, lend long, that they usually do.

But after reading through the Fed ‘s proposal on bank solvency, I conclude that they may not get the picture. They spend time on liquidity and other issues. With liquidity, it is uncertain how they will view repo markets. To me, those should be view as short-term finance of long dated assets.

During times of crisis, repo markets seize up, with rising repo haircuts. Maybe I’ve read the Fed’s proposal wrong, but it seems that it neglects repo funding, which had a large effect on the recent crisis.

If banks had to be able to size their activity to survive a rise in repo haircuts equal to half of the highest that we have seen, it would probably be enough to make the issue go away, because the haircuts would be less likely to rise as a result of that restraint.

Now, I appreciate the perspective of this article from Dealbreaker on the topic. All of the assets of the bank support all of the liabilities. In one sense, there are no assets that are tagged “equity” and others tagged “liability.”

P&C Insurance works a little different. In that, premium reserves are invested in high quality short-term debt. Claim reserves are invested in high quality debt similar to the period that claims are expected to be paid out over. The remainder (the equity) can be invested in risk assets in order to earn a decent return for shareholders. The idea is this: match liabilities with high quality assets of the same length, and take risk with the remainder of assets, realizing that they might might needed for liquidity in the worst case scenarios.

But really, banks should not be viewed differently. They should invest like P&C or life insurers. Invest in high quality assets equal to the terms of their liabilities — deposits (estimate stickiness), savings accounts (same), CDs (the term is known). After that, take risks with the remaining assets in ways that reflect their comparative advantage, realizing that they might might needed for liquidity in the worst case scenarios. Illiquid investments (e.g. private equity) should not be allowed for a majority of of those investments.

If banks don’t engage in asset/liability mismatches aka maturity transformation, most of the risks of bank runs will go away. And that is what I propose. Note that if that happens, average people will have to pay some fee each year to have a checking account. Banks would be liquidity utilities.

This fits under my rubric that the insurance industry is much better regulated than the banking industry. Were it in my power to do so, I would turn banking regulation over to the states, and leave to the Fed control of monetary policy only. You would soon see intolerant banking regulation, much like we see in insurance, and defaults would decline.